What Links the Euro and Chinese Rates?

Chinese Communist Party course trainees wearing Red Army uniforms stand in front of a Communist party flag.

Most well known cross-market correlations have a readily explicable back story, even if it usually oversimplifies the case.

That there should be a link between commodity prices and the currencies of major producers is not surprising, for example. Nor is the connection between top-rated government and corporate debt; both tend to serve similar purposes within investors’ portfolios.

However, analysts at Bank of America Merrill Lynch have unearthed a real left-field connection. They say the monthly, rolling correlation between five-year Chinese swap rates and the EUR/USD pair has jumped to 83% between 2011 and 2012 so far, from only 44% between 2007 and 2010.

This is clearly perplexing. Where on Earth is the back story for that?

As a freely-floating currency, the euro is part of arguably the largest, most open trade on Earth, the foreign exchange market, whereas China’s rate market, well, isn’t. It’s much more closed and far less liquid.

Nonetheless, this isn’t necessarily a complete black swan of a correlation. Perhaps trade is the back story. Obviously, China’s links with Europe are critically important. The European Union is the largest importer of Chinese goods, ahead of the U.S., Japan and South Korea. And, thanks to the euro zone’s endless crisis, China’s exports to the EU fell 5.6% in the first nine months of 2012.

“Because the EU is China’s largest export destination, the sharp declines in export growth to the EU from 2011, with no big offset from other regions, have very significant marginal impacts on China’s total exports, and hence its growth,” Bank of America wrote.

Indeed, its own regression analysis of moves in the euro, Chinese swaps and the Shanghai Composite index, suggests that since the start of 2011 the euro has been a bigger driver of Chinese rates than domestic stocks were. So perhaps there’s a glimmer of a reason for that high and rising correlation there.

However, it’s important not to get carried away here. The euro-zone’s debt mess has clearly elevated the euro’s link with Chinese rates, but it remains far, far less significant than overall prospects for Chinese growth.

Chinese rates and the EUR/USD exchange rate could also both be influenced by U.S. monetary policy. Even so, it’s a correlation worth watching.